Originally published in Blakes Bulletin on Energy - Oil & Gas, October 2007
In Penn West Petroleum Ltd. v. The Queen, 2007 TCC 190 (Penn West) the Court applied the income reallocation provision in subsection 103(1) of the Income Tax Act, R.S.C. 1985, c.1 (Canada) (Tax Act) by holding that an allocation of proceeds to one partner in the Penn West Petroleum partnership, in accordance with the terms of the agreement governing the partnership (the Partnership Agreement), was not reasonable in the circumstances, and accordingly reallocated the proceeds to all of the partners in proportion to their respective partnership interests. The October 2007 Blakes Bulletin on Tax provides an in-depth analysis of the judgment. What follows here is a high-level summary of the key facts of the case and the conclusions reached by the Court.
On February 17, 1994, PetroCanada sold its interest in certain producing properties (the TroCana Assets) for approximately CAD 170 million to two subsidiaries (the PetroCanada Subsidiaries) following which the TroCana Assets were subsequently contributed, on a tax-deferred basis, to a partnership formed between the PetroCanada Subsidiaries.
On April 22, 1994, the appellant, Penn West Petroleum Ltd. (Penn West) acquired the shares of the PetroCanada Subsidiaries for CAD 170 million. On July 1, 1994 Penn West transferred its own oil and gas properties to the partnership and renamed it the Penn West Petroleum partnership. Penn West subsequently transferred its interest in the PetroCanada Subsidiaries owning 97% of the Penn West Petroleum partnership (the Majority Interest Partner).
On December 29, 1994, Penn West entered into a letter agreement to sell some units to Phillips Petroleum Resources Ltd. (Phillips). The sale of the TroCana Assets triggered an ROFR in favour of Phillips, Suncor Inc. and B.C. Star Partners. Phillips decided to exercise its rights under the ROFR to acquire a portion of the TroCana Assets known as the "Blueberry Assets". In order to accomplish the sale, the Majority Interest Partner agreed to sell a 5.27% interest in the partnership to Phillips for CAD 14.1 million. Phillips could then take possession of the assets by relying on certain existing clauses in the Partnership Agreement which allowed a partner to cause the partnership to redeem such partner’s units in exchange for a specified interest in any one or more of the partnership properties designated by such partner. The Partnership Agreement further provided that any income or loss realized, or proceeds of disposition deemed to be received, by the partnership as a result of such a distribution of partnership property would be allocated to the partners to which the distribution was made. Such a clause is common in resource partnerships and, as was noted by Chief Justice Bowman in his decision, it essentially attributes to a partner to whom property of the partnership is distributed the income tax consequences of such distribution with the net result that the partner acquires the resource property distributed without tax pools. This type of transaction has been utilized in transactions where the vendor is short on tax pools.
On February 24, 1995, the Blueberry Assets were transferred to Phillips in satisfaction of Phillips’ interest in the partnership. In accordance with the provisions of the Partnership Agreement, Phillips was allocated all of the proceeds of the disposition deemed to have been received by the partnership as a result of the transfer. The Minister of National Revenue reassessed Penn West on the basis that it should have been allocated 92.82% of the proceeds allocated to Phillips, in accordance with Penn West’s interest in the partnership on the date that Phillips withdrew as a partner.
The Tax Court found that the issue in question was "whether the entire deemed proceeds of the disposition of the Blueberry assets can be allocated to Phillips for tax purposes by reason of article 3.17 [of the Partnership Agreement] despite the fact that for balance sheet purposes Phillips had only a 5.27% interest" (para. 26). Specifically, the issue was whether the allocation of the proceeds of disposition of the Blueberry Assets to Phillips contravened subsection 103(1) of the Tax Act, which reads as follows (emphasis added):
(1) Where the members of a partnership have agreed to share, in a specified proportion, any income or loss of the partnership from any source or from sources in a particular place, as the case may be, or any other amount in respect of any activity of the partnership that is relevant to the computation of the income or taxable income of any of the members thereof, and the principal reason for the agreement may reasonably be considered to be the reduction or postponement of the tax that might otherwise have been or become payable under this Act, the share of each member of the partnership in the income or loss, as the case may be, or in that other amount, is the amount that is reasonable having regard to all the circumstances including the proportions in which the members have agreed to share profits and losses of the partnership from other sources or from sources in other places.
In finding the allocation at issue to be unreasonable in the circumstances, Bowman C.J. cites a number of facts he considered material. According to Bowman C.J., the allocation clause of the Partnership Agreement "may have had its genesis" (emphasis added) in a desire to allocate proceeds of disposition back to a partner that had contributed assets into the partnership on a tax-deferred basis under s. 97(2) of the Tax Act. Since Phillips had not contributed assets to the partnership, this rationale for the allocation provision did not apply to it. In a separate part of the Reasons for Judgment, the Court expressly rejects the argument raised by counsel for Penn West that the existing clause of the Partnership Agreement permitted the assets to be extracted and the income to be allocated on the basis undertaken. According to Bowman C.J., the Partnership Agreement was amended "to permit Phillips to designate the properties (presumably the Blueberry assets) that it wanted to take out of the partnership".
The trial decision (which, it is understood, has been appealed to the Federal Court of Appeal) has raised considerable uncertainty with respect to the proper application of allocation clauses such as the one at issue in Penn West. For an in-depth analysis of the decision and a detailed discussion of its possible implications, please refer to the case comment contained in our October 2007 Blakes Bulletin on Tax, Penn-West Decision Reallocates Partnership Income.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.